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Stress Testing in Connecticut Shows Reforms Stabilizing State Pension System

Stress Testing in Connecticut Shows Reforms Stabilizing State Pension System

Connecticut has taken critical steps in recent years to stabilize its underfunded pension systems for public employees, but state officials are rightfully concerned about whether those actions will be sufficient when the next recession hits. That’s why lawmakers passed a measure in 2017 requiring annual “stress tests” of the State Employees Retirement System (SERS) and the Teachers’ Retirement System (TRS).

Stress testing involves the simulation of a range of scenarios for economic projections and investment returns to give policymakers a better sense of potential liabilities and costs. That information, then, can help guide retirement system investments—and state budgets.

In mid-December, then-Governor Dannel P. Malloy (D) released the results of the state’s first stress test, conducted by The Pew Charitable Trusts. The analysis found that although reforms to SERS had improved the system’s fiscal health, additional changes to the teachers’ system were still needed to avoid substantial cost increases that could limit the money available for other state spending in the event of a downturn.

Malloy, who left office on January 9, said the testing showed the effectiveness of the state’s reforms.

“This analysis demonstrates that actions we took to restructure and reform SERS have been incredibly effective and provide the path for what we need to do with TRS to greatly improve the state’s financial future,” he said in December. “Our pension problems have haunted our state and impeded our growth for decades, but by fully funding our obligations, reforming the amortization methods to stabilize annual payments and mitigate additional growth in the unfunded share, and creating a hybrid system for [new] employees, we have solidified our state employees’ system—even when faced with a recession.”

Malloy said the new administration, led by Governor Ned Lamont (D), and the General Assembly can use stress testing, the data it produced and available resources to put the pension system for the teachers on “a sustainable and solvent course.”

Pew’s Connecticut stress test focused on the risk of plan investments—the likelihood that investments deviate from expected performance—and contribution risk—the likelihood that contributions fall below what’s needed to meet funding objectives. Because earnings on investments typically make up the largest share of pension fund revenue, lower returns or losses need to be offset by higher contributions from the state government and workers.

Specifically, the analysis found that:

If investment returns fall short of the expected 6.9 percent a year for SERS, and 8 percent a year for TRS, the state budget would be exposed to potentially unaffordable spikes in required pension contributions. For example, if returns average only 5 percent each year for 30 years or more, Pew estimates that required state contributions would increase from 13 percent of revenue to over 19 percent by 2028. This could crowd out as much as $10 billion in other government spending by 2030.

Although Connecticut SERS faces minimal exposure to fiscal distress in a recession, TRS’ funded level could plummet if the state fails to raise contributions. The divergent outcomes reflect recent changes to SERS’ assumptions, contribution policy, and plan design to protect the system from insolvency, despite its low funded rate of 36 percent. In contrast, TRS would face declining assets if contributions increased only at the same rate as state revenue—which also would be reduced in an economic downturn. Even without a recession, the state may need to boost contributions over time to ensure the fiscal sustainability of the teachers’ plan.

Recent reforms to SERS demonstrate positive results in managing financial market volatility and mitigating investment risk. The reforms placed new state employees in a hybrid plan that combines a smaller defined benefit, or traditional pension plan, with a defined contribution component. It also includes a risk-sharing provision that automatically raises workers’ contributions if investment returns fall short of the target. These changes are projected to lead to savings of $1 billion to $2.5 billion over 30 years, depending on investment performance.

Finally, the low funded levels of both plans could result in persistently high costs for decades if investments underperform. The state’s current contribution levels help diminish the likelihood of fiscal distress for the retirement systems, but realistic and achievable plans to reach full funding are needed to lower the impact of pension costs on the state budget over time.

Experiences in Connecticut and elsewhere make clear that stress testing is not just an academic exercise: Policymakers and budget officials need tools that provide information accessible to all stakeholders responsible for assessing whether current or proposed policies are sufficient to effectively manage financial market volatility throughout the business cycle.

The emergence of such testing as a routine and publicly reported practice is a critical development given that pension debt and investment risk are at all-time highs throughout the 50 states. Public employee retirement systems remain particularly vulnerable to the next recession, which many experts predict is likely within the next two to three years.

Connecticut is one of five states that have adopted formal requirements for stress testing since 2017. With the recent updates to national actuarial standards on risk reporting, additional states are expected to follow Connecticut’s lead in the months and years ahead.

Greg Mennis is the director of The Pew Charitable Trusts’ public sector retirement systems project and Michael Lowenthal is a manager with the project.